Archive for July, 2011

The exclusion of up to $500,000 of gain* from the sale of a taxpayers’ primary residence is one of the sweetest plums the current Internal Revenue Code has to offer.

Curiously, Section 121 of the Code — the governing authority for the exclusion — doesn’t define the term “principal residence.” Rather, it simply requires that during the 5-year period ending on the date of the sale, the taxpayer must have owned and used the home as the taxpayer’s principal residence for periods aggregating 2 years or more.

This analysis is straightforward when a taxpayer calls one place home over the two year period preceding the sale. But what if the taxpayer was a big wheel down at the cracker factory, earning enough to retire early and live out his days splitting time between luxury homes in Beverly Hills and Aspen? Which one is his primary residence?

In the case of a taxpayer using more than one property as a residence, whether property is used by the taxpayer as the taxpayer’s principal residence depends upon all the facts and circumstances. If a taxpayer alternates between 2 properties, the property that the taxpayer uses a majority of the time during the year ordinarily will be considered the taxpayer’s principal residence. In addition to the taxpayer’s use of the property, relevant factors in determining a taxpayer’s principal residence, include, but are not limited to—

The taxpayer’s place of employment;

The principal place of abode of the taxpayer’s family members;

The address listed on the taxpayer’s federal and state tax returns, driver’s license, automobile registration, and voter registration card;

The taxpayer’s mailing address for bills and correspondence;

The location of the taxpayer’s banks; and

The location of religious organizations and recreational clubs with which the taxpayer is affiliated.

In Wickersham v. Commissioner, 2011-178 (7.28.11), the Tax Court was asked to analyse these factors to determine whether the sale of the taxpayers’ Iowa residence qualified for the Section 121 exclusion. The scrutiny was necessitated because the Wickershams — apparently thirsting for more excitement and adventure then the Hawkeye State had to offer — also spent time at a second home in Omaha, Nebraska.

Complicating the analysis was inconsistent reporting by the Wickersham’s on their federal and state tax returns. The federal returns from 2001-2005 used the Nebraska mailing address, while the 2005 return used the Iowa address. In addition, the Wickersham’s filed Nebraska resident state income tax returns in 2002 and 2003 (presumably to qualify for a liquor license owned by the couple which was available only to Nebraska residents), but Iowa resident returns in 2001, 2004 and 2005.

In its decision, the Tax Court looked past the inconsistent tax return reporting and determined that the majority of the factors indicated that the Iowa home was the Wickershams’ principal residence. The court cited the following:

Wickersham’s hosted the majority of their personal and family events and obligations in Iowa;

Mr. Wickersham received cancer and hernia treatment in Iowa;

The Wickersham’s 28 children and grandchildren resided in Iowa;

The Wickersham’s doctors, lawyers, and bookkeepers were located in Iowa

After the Wickersham’s sold their Iowa home, they purchased their replacement home in Iowa, an indication that the taxpayers’ never intended to permanently reside in Nebraska.

The Detroit News reports that the ‘Love Letter’ creator owes $837,000 in delinquent federal taxes. The IRS filed the tax lien against the 44-year-old Chicago native on Jan. 6, 2010, with the Cook County Recorder of Deeds.

While equally implausible, sadly, only the first part of that title is true.

In Mondell0v. Commissioner, T.C. Summary Opinion 2011-97 (7.25.11), a part-time web developer ran his business as a sole proprietorship. He worked hard on his craft, as most sole proprietors do. Unlike most sole proprietors, however, Mondello saw fit to “accrue” a $50,000 deduction to himself for services rendered but not yet paid.

If you find this confusing, you’re not alone. Sole proprietorships — unlike S corporations, C corporations, or multi-member partnerships — are not given any independent tax significance apart from their owner. In other words, from a tax perspective, you are your sole proprietorship, and your sole proprietorship is you. It would then follow that paying a salary from your sole proprietorship to yourself is as meaningless a gesture as lending $40 bucks from your right hand to your left foot.

For Mondello, however, the $50,000 accrual resulted in a decrease in taxable income without an offsetting income pickup, as the sole proprietorship was on the accrual method and he reported his income on the cash method. The deduction also reduced Mondell’s income subject to self-employment tax and resulted in a reduction in adjusted gross income that allowed for an increased medical expense deduction.

As one might imagine, the IRS disagreed with Mondello’s position and denied the deduction. The Tax Court sided with the IRS, noting:

Under the accrual method a taxpayer is not entitled to deduct an expense “if there is no legal obligation during the taxable year to make such payment.” The word “liability” means “The quality or state of being legally obligated or accountable; legal responsibility to another or to society, enforceable by civil remedy or criminal punishment”. Should petitioner have “refused” or become unable to pay himself, there would have been no legal consequence. He would not seek forced collection from himself, nor would he be able to sue himself in a court of law to obtain a judgment against himself for any amounts he “owed” to himself, even if he were so inclined. There was no legal obligation during the taxable year, or any other year for that matter, for petitioner to pay himself anything.

Ladies, if you’re still single, I’ve got some unsettling news for you: married life ain’t all longingly-staring-into-each-other’s-eyes-while-sharing-the-perfect-sunset. Men are repulsive, reprehensible creatures. We leave the toilet seat up. Our discarded toenail clippings find their way into the bed sheets with alarming frequency. And yes, on occasion, we’ll underreport millions in federal income tax before running off with a comely 23-year old Mary Kay sales rep, leaving you with three unruly kids and a hefty tax bill.

Luckily, the IRS has your back. While the Service is virtually powerless to remedy toilet seat and toenail problems, Section 6015 of the Code permits an “innocent spouse” to seek relief from a joint tax liability. Section 6015 provides three potential sources of relief:

Section 6015(b) provides a “general” relief rule available to all joint filers, including those who are still married to each other.

Section 6015(c) covers additional relief available to joint filers who at the time an election is filed (1) are divorced or legally separated from the other party to the joint return in question or (2) have lived apart from the other party for the preceding 12 months.

Lastly, when neither 6015(b) nor 6015(c) applies, an innocent spouse may still gain relief under the equitable relief provisions of Section 6015(f). Under the related regulations, a claim for relief under Section 6015(f) had to be made within 2 years of the date collection activities started against the requesting spouse.

Notice 2011-70, issued today, liberalizes the time frame a spouse has to request this late relief. Under the Notice — which was written in response to a number of court cases challenging the validity of the “two-year” regulations — a request for equitable innocent spouse relief must now be made within the 10-year period for collections under Section 6502.

As for the Notice’s impact on current and future requests:

The IRS will no longer apply the two-year limit to new equitable relief requests or requests currently being considered by the agency.

A taxpayer whose equitable relief request was previously denied solely due to the two-year limit may reapply using IRS Form 8857, Request for Innocent Spouse Relief, if the collection statute of limitations for the tax years involved has not expired.

Taxpayers with cases currently in suspense will be automatically afforded the new rule and should not reapply.

The IRS will not apply the two-year limit in any pending litigation involving equitable relief, and where litigation is final, the agency will suspend collection action under certain circumstances.

Recently, the bipartisan Senate “Gang of Six” has proposed a plan that would slash the deficit while simultaneously reducing the collective tax bill of American taxpayers by $1.5 trillion, courtesy of an extensive overhaul of the Internal Revenue Code.

I’ll spare you much in the way of discussion regarding how these savings are determined, as they are computed off a baseline projection that assumes many of the current tax provisions — such as the reduced Bush-era tax rates and the AMT exemption — will disappear as currently planned at the end of 2012 and 2011, respectively. This is an important and unlikely assumption, as few believe these tax breaks would be abruptly removed from the tax landscape under any scenario.

Instead, let’s focus on what the proposal would actually mean to your tax bill. The “Gang of Six” plan would:

Simplify the tax code by reducing the number of tax expenditures and reducing individual tax rates, by establishing three tax brackets with rates of 8–12 percent, 14–22 percent, and 23–29 percent (the current maximum individual rate is 35%).

Permanently repeal the $1.7 trillion Alternative Minimum Tax.

Reform, not eliminate, tax expenditures for health, charitable giving, homeownership, and retirement, and retain support for low-income workers and families. It is believed the deduction for mortgage interest (currently applicable for the first $1.1 million of qualified debt), would be greatly reduced.

Retain the Earned Income Tax Credit and the Child Tax Credit, or provide at least the same level of support for qualified beneficiaries.

Establish a single corporate tax rate between 23 percent and 29 percent, raise at least as much revenue as the current corporate tax system, and move to a competitive territorial tax system.

Although unstated in the proposal, popular opinion is that the plan would also offer the following:

The current 15% tax rate applied to long term capital gains and qualified dividends would be removed, and the tax on these items would be the same as the tax rate applied to ordinary income.

The current exemption under S103 for state and municipal bond interest would be removed.

The deduction for state and local taxes and miscellaneous itemized deductions would be removed.

Accelerated depreciation and the S199 deduction would disappear.

As you can see, while the “Gang of Six” claims that these changes will reduce taxes, this is based off the highly unlikely assumption that our collective tax bill would have greatly increased without this proposal, as the Bush-era tax cuts and AMT patch would disappear. If you were to compare the proposal to a much more likely future baseline (extension of the Bush-era cuts, at least for those earning less than $250,000, and a continuation of the AMT patch), the changes proposed by the “Gang of Six” would likely increase taxes due to the removal of so many key deductions and credits.

Of course, the real winner should this proposal come to fruition is me, or if you’d prefer a less selfish perspective, tax advisors in general. Any overhaul of the tax code would add an element of job security for the number-crunching CPA crowd, as we’ll be charged with the unenviable task of understanding and implementing these dramatic changes to an already near-incomrehensible series of laws.

Nephew moves in with Uncle – Nephew performs occasional services for Uncle — Uncle cuts Nephew $50,000 in checks with “loans” written on the memo line – Nephew treats the amounts as loans and does not reflect the $50,000 as income.

That’s where the IRS comes in, assessing a deficiency on Nephew, asserting that the payments reflected compensation for the services provided to Uncle.

In determining whether the payments represented loans or compensation, the Tax Court cited cases previously decided by the Ninth and Seventh Circuits to develop the following eight factors that required analysis:

(7) the likelihood that the loans were disguised compensation for services; and

(8) the testimony of the purported borrower and lender.

In holding that the payments were nontaxable loans, the Tax Court held that factors #1, 2, 3, 4, 7, and 8 were in Nephew’s favor, with factors #5 and 6 neutral.

The most noteworthy aspect of the ruling came in the court’s decision that Nephew had the ability to repay the amounts transferred (factor #1), as Nephew had few assets, a $200,000 mortgage, and an outstanding previous debt to Uncle, with no reliable source for future earnings. The court stated:

However, Nephew and Uncle reasonably expected that some of Uncle’s startup enterprises would become profitable and enable Nephew to repay his loans within a five-year period. Uncle had told Nephew: “We’re going to get something going down here and you’re going to have all the money in the world and you can pay me back.”

For some reasons unbeknownst to me, the Tax Court actually lent credence to this seemingly inane bit of rah-rah-go-team blind optimism. I would have thought the first factor would be measured purely on the borrower’s actual ability to repay the loan, rather than his potential ability to repay the loan. But then I’d be wrong.

Geez, if you can’t trust your hard-earned millions with the guy whose audiotape on financial success you just bought off the Barnes & Noble clearance rack for $3.99, then who can you trust?

Pity poor Dominick Vincentini. He invested nearly $2,000,000 with Keith Anderson, creator of the “Gateway to Financial Freedom” audiocasette series, and was promptly robbed blind. The irony here of course, is that if you’ve got a couple million to burn on misguided investments, I’d argue that you already enjoy more financial freedom than you likely deserve.

If this is possible, things went from bad to worse for Vincentini last week, when the 6th Circuit denied his appeal of his earlier Tax Court decision, holding that Vincentini was not permitted a theft loss deduction related to the stolen funds. The crux of the case was not whether a theft had occurred, but rather the timing of the theft, with the Tax Court ruling that Vincentini still maintained a reasonable prospect of recovery in the year he deducted the stolen funds.

From the 6th Circuit:

In 1999…Vincentini decided to invest in two of [Anderson’s] programs: the Loan Four Program and the Look Back Program. Vincentini claims that he was promised annualized returns of 30 to 50 percent. All told, he invested $800,000.00 in the Loan Four Program [along with $950,000.00 in the Look Back Program]. In reality, however, the loans affiliated with the Look Back Program were illusory; AAA simply used the fake loans to generate and then steal from investors the “fees” needed to obtain the fictional capital.

Andersen and his cronies were arrested in 2001 and convicted in 2002 for running their Ponzi scheme, and ordered to pay restitution to their bilked investors. These events “fixed” the presence of a theft loss for Vincentini, but that is only part of the two-prong test for taking a deduction. Did Vincentini also make enough of an effort to recover his stolen money to satisfy the following requirement of Treas. Reg. 1.165-1(b):

If a casualty or other event occurs which may result in a loss and, in the year of such casualty or event, there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, no portion of the loss with respect to which reimbursement may be received is sustained, for purposes of section 165, until it can be ascertained with reasonable certainty whether or not such reimbursement will be received.

By May of 2001, Vincentini was actively trying to withdraw his investment from the Loan Four Program. There were also phone conferences between the investors and Costa Rican attorneys exploring whether to begin legal proceedings against the principals of AAA. Although Vincentini states that he participated in at least one of these conferences, he ultimately chose not to retain legal counsel to pursue his money because he thought such efforts to be in vain. Vincentini further says he tried, unsuccessfully, to withdraw his investment from AAA by submitting several “directives” to Kuzel and other principals requesting the release of his funds.

Unfortunately, these efforts were not enough to convince the Tax Court or the 6th Circuit that a reasonable prospect of recovery did not exist at the end of 2002:

At trial he declined to offer anything more than his own testimony to show that at the end of 2002 there was no reasonable prospect of recovery. Even though Vincentini testified that he had both sent written requests to officials from AAA demanding the return of his money and participated in conference calls with Costa Rican attorneys, such statements were uncorroborated and self serving. That Vincentini did not say that he subjectively believed that there was no reasonable prospect of recovery further supports the Tax Court’s ultimate conclusion.

Based on this reasoning, the 6th Circuit upheld the Tax Court’s denial of the theft loss. The result seems particularly harsh, as by the end of 2002 the responsible parties had already been convicted. The 6th Circuit maintained, however, that even with the convictions Vincentini could have attempted to recover his money through court-ordered property forfeitures or other restitution.

What’s the lesson here? Far be it for me to stereotype, but I wouldn’t expect a man named Dominick J. Vincentini to passively succumb to the theft of $2,000,000. But he did, and it backfired on him in the form of a denied theft-loss deduction. And while case law has established that “you need not refrain from taking a loss deduction simply because there exists a remote or nebulous possibility of recovery,” it would certainly appear that you’ve better be preared to prove that you’ve exhausted every avenue of recovery prior to deducting the stolen funds.

The items in this blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation. A select group of Tax Professionals of WithumSmith+Brown write Double Taxation, and any opinions expressed or implied are not necessarily shared by anyone else at WithumSmith+Brown.

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